In the course of negotiating a purchase and sale agreement during the M&A process, business people may rightly wonder which provisions actually matter. The section of the agreement dealing with the purchase price is the most interesting section for both buyers and sellers, but the lawyers may spend hours negotiating indemnities, caps, baskets, definitions, MAE clauses, covenants, and other arcane provisions.
Which of these provisions are actually likely to result in litigation?
Let’s briefly discuss the provisions that are unlikely to result in disputes or litigation:
First, indemnities are not typically litigated. Indemnities can be important, and in certain circumstances may provide a buyer (much less frequently, a seller) some protection post-closing, but although lawyers love to fight over indemnities, they are actually aren’t typically invoked post closing.
One way to think about indemnities is that they are an insurance policy written by someone who isn’t in the business of writing insurance. Think about how challenging it can be to get an insurance company to process a claim. Now imagine that the insurance company has never processed a claim before, doesn’t have policies and procedures in place to process claims, and has no expectation that they ever will be required to cover an arguably insured loss.
If you’re a buyer expecting a seller to fulfill an indemnity obligation, you need an easy source of funding that indemnity obligation, like an escrow account or offset against a seller note, and an easy and fast dispute resolution mechanism.
Second, closing conditions are not frequently litigated in SMB M&A transactions. There are certainly examples of this sort of litigation in larger transactions, but in small deals, whether closing conditions are met just isn’t a matter typically worth litigating over. Courts are hesitant to force parties to do a deal that one of them does not want to do, so the best case scenario for someone seeking to enforce an obligation to close a transaction over another party’s objections is a damages award. The amount of such an award is speculative enough that it’s not frequently worth the time and effort to litigate.
There are, however, a few M&A matters that are likely to result in disputes, occasionally rising to litigation.
First, earnout provisions very frequently result in disputes. The more complicated the earnout provision, the more likely it is to result in a disagreement, potentially leading to litigation. Buyers will seek to minimize the amount paid under an earnout, believing that any issues in the business were undisclosed by the seller and therefore any underperformance should directly result in reduction in the earnout amount. Sellers will believe that buyers are manipulating results to reduce the earnout.
The solution is to design the earnout to follow a few clear metrics, and include a very clear, fast mechanism for resolving disputes about the numbers (for instance, choosing an accounting firm to validate an EBITDA-based metric, and making that validation binding).
Second, restrictive covenants can result in disputes post-closing. Most sellers are bound by non-competes and non-solicitation covenants; these are typically regarded as more enforceable by courts in the context of the sale of a business than in employment contexts. Buyers should reasonably be able to expect that sellers won’t set up a competing business down the block, and will refrain from hiring key employees away from the business or attempting to cause vendors to stop working with the sold business. Sellers, on the other hand, may sell the business, take some time off, and then discover that they want to continue working after a time. The scope of a non-compete or non-solicitation can matter greatly in allowing the parties to move forward without disputes.
Finally, although not typically baked into the purchase agreement itself, the terms of employment, consulting, or transition service agreements with sellers can lead to disputes. Payment terms, length of employment, scope of services, and (maybe most importantly) scope of authority and reporting lines are some key items to focus on to avoid post-closing disputes.
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